Macro

Global Growth Scare: What's Real versus Imagined

August 24th, 2015 | By Nick Sargen

Highlights

  • Risk assets have sold off considerably amid concerns about China and emerging markets (EM) in the wake of plummeting prices for oil and EM currencies. The catalysts were actions by China's government to prop up the domestic stock market and to liberalize the country's exchange rate policy.
  • While China's economy is a "black box" for most investors, evidence of a slowdown in emerging economies is compelling: Growth in Q2 was the weakest since the Global Financial Crisis.
  • Thus far, the U.S. economy has performed very well despite the slowdown abroad, although market participants are nervous about the spill-over to the U.S.
  • Our own view is the U.S. economy is on solid footing; accordingly, we are overweight credit risk in fixed income portfolios. However, we are positioning equity portfolios defensively, as the stock market succumbs to its first correction in more than four years.

Background: Worries about China Spread to Emerging Markets

In two previous commentaries, I discussed concerns market participants had about China's economy in the wake of government actions to prop up the domestic stock market and to alter the country's exchange rate policy.[1] My conclusions were that the stock market actions were misguided; however, the decision to allow greater exchange rate flexibility was sensible and consistent with long-standing objectives to make the exchange rate more market-determined. Nonetheless, while I continue to hold these views, there is no denying the change in exchange rate policy was widely interpreted as a conscious effort to devalue the RMB, which, in turn, contributed to pressures on EM currencies, as well as oil prices.

Recognizing this, I address the following issues in this commentary:

  • How extensive is the slowdown in China and the EMs?
  • What is the risk of spill-over to the US?
  • How should investment portfolios be positioned?

Weaker Growth in Emerging Economies

The controversy over China's growth rate is occurring at a time when official statistics indicate the pace of activity accelerated in the second quarter to 7.5% from 5.5% in the first quarter. There is widespread skepticism of this number, however, considering a host of indicators including industrial production, electrical usage, and exports all point to continued softness. Indeed, the China Activity Proxy developed by Capital Economics suggests the economy grew at a rate closer to 5%.[2] And while some observers point out that the services sector fared much better than the manufacturing sector, the latest policy actions by the Chinese authorities have added to skepticism about the economy. Indeed, lack of transparency makes China's economy look like a "black box" for most investors.

By comparison, the evidence of a broad-based slowing in growth for emerging economies is compelling: According to J.P. Morgan and Capital Economics, EM growth in the second quarter was the weakest since the global expansion began in mid-2009. The most troubled economies include Argentina, Brazil, Russia, and Venezuela, which are in recessions that could deepen further, as these countries lack the flexibility to ease policies due to pressures on their currencies. Capital Economics estimates that GDP in Emerging Europe contracted in Q2 mainly due to the worsening crisis in Russia, while growth in Latin America appears to have been flat, as the worsening conditions in Brazil impacted the region. Emerging Asia has fared the best of any region; however, two prominent economies with close trading ties to China – South Korea and Taiwan – have experienced weak export growth.

In the wake of these developments, market participants are assessing the potential spill-over to advanced economies. According to the IMF, a one percentage point decline in EM growth is associated with declines of growth in Japan and the eurozone of 50 basis points and 35 basis points, respectively. In both cases, the respective economies slowed in Q2, with Japan posting a decline while the eurozone was barely positive. Consequently, there is valid reason for market participants to be concerned about an economic slowdown abroad.


Potential Spill-over to the United States

Amid the worries about China, I have not been overly concerned about the spill-over to the U.S. economy for two reasons:

First, the U.S. economy has proved to be resilient to weakness in the rest of the world both during the recessions in Japan and the eurozone one year ago, as well as during the slowdown in emerging economies this year. In 2014, the U.S. economy performed poorly during the first quarter due to weather-related reasons, but it then gained traction in the remainder of the year in which real GDP growth averaged more than 3.5%. The same pattern is evident this year, as the initial estimate of Q2 GDP growth is expected to be revised above 3.0%. Furthermore, key indicators such as jobs growth and Institute for Supply Management (ISM) services suggest the U.S. economy is on solid footing.

Secondly, economic and financial ties between the United States and China are not as great as press accounts would suggest. Exports to China, for example, account for less than 1% of GDP. Accordingly, estimates of the impact that a one percentage point reduction in China's growth rate would have on the U.S. economy range from 7 to 11 basis points, depending on the underlying assumptions. Nor are the financial linkages with China large: Corporate profits and revenues derived from China amount to only 0.5% of GDP and 2.5% of S&P 500 revenues, respectively.

One caveat is that the U.S. would be more vulnerable if weakness in China contributed to contagion in emerging economies. This phenomenon was evident during the Asian Financial Crisis in 1997-98, when a problem in a small country –Thailand–spread first to Southeast Asia, then to North Asia, and on to Latin America and Russia, before it impacted U.S. financial markets in September of 1998. In this regard, investors today appear to be most concerned that downward pressures on prices of commodities and currencies could spawn crises in several prominent emerging economies. While the probability of global contagion is relatively low, it cannot be ruled out, considering that capital outflows from emerging economies since mid-2014 are estimated to be in the vicinity of $1 trillion. (See Financial Times, August 19, 2015.)


Portfolio Positioning

In the wake of these developments, we are continuing to overweight credit risk in fixed income portfolios on grounds that the U.S. economy is not at risk of recession, and credit spreads are attractive. The sectors that have been hurt the most include energy and metals and mining, but credit spreads have also widened in most other sectors. While it is too early to tell when credit markets will stabilize, there are attractive opportunities as a result of the sell-off. Interim volatility should be anticipated, however, as risk premiums increase to reflect many of the factors discussed.

By comparison, we are positioning equity portfolios more defensively, with an emphasis on high quality names, for several reasons. First, equity valuations are stretched, and the broad market appears headed for its first correction of 10% in more than four years. Second, corporate profits have levelled off in the past year, partly in response to declines in the energy sector. Third, the Federal Reserve may be on the cusp of tightening monetary policy for the first time in nearly a decade, although recent developments have lessened the likelihood the Fed will raise rates in September.


[1] See blogs posted on August 6 and on August 12.

[2] See "Emerging Market Chart Book', August 2015.